Find out why volatility plays a key role in valuing awards based on total shareholder returns.
Volatility is a measure of how the price of a security, such as a stock, changes over time. It is measured as a percentage with a low volatility percentage indicating that the price of the security is relatively stable over time, and a high percentage indicating large price fluctuations. Volatility may be greater than 100% and may be based on historical volatility, implied volatility or a combination of both, depending on the circumstances.
Historical volatility is a statistical measure of the price movement of a security over a given period. It is a calculation of the dispersion of the average price over the period. Although historical volatility is widely used to measure stock-based compensation, implied volatility is considered a more reliable measure because it is forward-looking. Implied volatility is based on actively traded options and is an indication of the market’s view of how a security’s price will change in the future.
The performance objectives of the various types of stock-based compensation awards granted to employees all have the same goal in mind: to encourage strong performance that leads to growth in value. However, there are many forms of awards and an entity’s volatility can affect awards with different structures in different ways.
Total shareholder return awards
Total shareholder return (TSR) is a measure of financial performance. TSR measures the price of a security at the end of a period relative to the price at the beginning of a period and can be positive or negative, depending on whether the price has gone up or down. TSR awards can be based on a company’s absolute or relative TSR measured against a peer group of companies and/or an index.
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TSR allocations are valued using Monte Carlo (MC) simulation models that use fixed market inputs (e.g. price, volatility, risk-free rate, etc.) and a random error term to simulate the future prices. The simulation is repeated thousands of times (sometimes even millions) to determine the probability of certain outcomes or the average outcome of the simulation iterations.
Absolute total shareholder return
Absolute TSR pricing is simple; if a company granting the reward has a higher return on its outstanding shares over a set period, the recipients earn additional shares and larger payouts. This is an ideal type of reward if a company wishes to reward only stock price appreciation, regardless of market conditions beyond the company’s control that may affect the stock price. action, such as a recession or other market event affecting all market participants.
Higher volatility increases the valuation of an absolute TSR award. To illustrate this, several MC simulations were run in which volatility was adjusted and other inputs held constant for an attribution based on a company’s annualized TSR over a three-year performance period. The future payout can range from 0% to 200% of the initial number of units granted depending on the company’s three-year annualized TSR. Although high volatility causes a company’s TSR to fall to lower threshold levels in a greater number of iterations, the high prices that sometimes occur multiplied by the high payout percentage in the upper threshold cause an increase of the overall fair value on average.
Relative total shareholder return
Relative TSR rewards have become common in recent years when overall market volatility has been high. The purpose of relative TSR awards is to reward recipients when a company outperforms selected companies. Absolute TSR awards may not reward recipients for outperforming competitors when all participants in a particular sector are performing poorly.
“Volatility plays an important role in the valuation of TSR-based awards. However, the magnitude of its effect may be more pronounced or somewhat attenuated depending on the terms of the reward.
Volatility can have a more ambiguous effect on the relative results of the TSR Monte Carlo simulation depending on how the payout is structured. As noted earlier, the high volatility of an absolute TSR results in a higher fair value due to iterations with large payouts, even though the high volatility more frequently places a company in lower threshold buckets. This effect is still true with relative TSR attributions, but is somewhat muted, and high volatility (relative to peers in this case) does not affect fair value as drastically as with absolute TSR attributions.
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However, when a negative condition is added to TSR awards, high volatility has a much more pronounced effect on the fair value of the award. A common negative condition is when a subject company has a negative TSR, the payout percentage is capped at 100%. With these rewards, high volatility relative to its peers has a similar and large effect on fair value when a company hits lower threshold levels more often, but iterations with large and positive TSR result in a significant increase in fair value. just value.
Volatility plays an important role in the valuation of awards based on TSR. However, the magnitude of its effect may be more pronounced or somewhat attenuated depending on the terms of the attribution. When a company considers awarding a performance-based reward using total shareholder return, it must carefully consider how to structure the reward to ensure that it rewards desired behavior and does not give away inadvertently payouts higher or lower than expected for certain levels of performance.